BWFA invests a piece of almost every client account in foreign stocks and bonds. In this article we give you our point of view about why these securities add value to our client accounts, and how we participate in foreign markets.
Foreign securities have three important benefits to our clients:
- First – Foreign securities markets are becoming bigger relative to the United States markets. In 1970 the United States represented 66% of the total world stock market capitalization. By 2004 that percentage had decreased to only 45%, and it is expected to continue to decline. With more than half the investment opportunities now abroad, we think it is important for our clients to participate.
- Second – Foreign securities markets are not perfectly synchronized with U.S. markets. This benefits our clients by adding a category of investments that may grow at a time when U.S. securities may be declining. In seven of the last 20 years, they have been the top performing category of investments as compared with other large categories, such as domestic large stocks, small stocks, long term treasuries, and 30-day treasuries.
- Third – Foreign securities are denominated in different currencies, which offers our clients another level of diversification. This means that our client portfolios will maintain their value better during periods when the U.S. dollar is weak.
The benefit of mixing foreign and domestic securities is more consistent, less volatile performance for our clients without reducing the long-term return. The current year is a good example of how foreign stocks act differently from U.S. stocks. For the year ending December 31, 2005, the Morgan Stanley Capital International Europe, Australia, and Far East (EAFE) Index, a broad measure of foreign stock markets, was up 10.9%, while the S&P 500 Index was up only 3.0%.
As with any investment category, the key is to hold an appropriate balance of foreign securities relative to other asset classes. We do not recommend holding more than 25% in foreign securities because they tend to be more volatile than U.S stocks and bonds. In addition to the currency risk, prices of foreign securities go up and down more, because they are often smaller, their exchanges lack the sophistication and depth of our markets, and they are subject to the whims of large international cash flows. It is not unusual for foreign stocks to swing from being the best performing category of investments to the worst performing category year after year. Since one of our primary goals is to limit risk, we want to hold only a moderate amount of foreign securities.
Although we would prefer to own individual foreign securities, we generally use high quality, low cost mutual funds to participate in foreign markets. The necessary information available on foreign companies is difficult to obtain. In addition, we would need reliable information about each country’s securities regulations, accounting rules, economic condition, and political risk in order to participate in an intelligent way. Therefore, we choose mutual fund managers who specialize in this field and leave to them the selection of which countries to buy in and which stocks and bonds to buy. We generally prefer to invest in large stocks in industrialized countries with a well established rule of law, such as European states. However, we have taken note of the incredible growth in the Pacific Rim countries and also favor funds with an allocation in that area.
Objective studies show that a small allocation (not more than 25%) to foreign securities is beneficial to overall portfolio performance. If BWFA is managing your portfolio, you can be assured that you have appropriate exposure to this important asset class. If we are not managing your portfolio, you should take a look to see if you are missing valuable opportunities in foreign securities.